Can Revenue Bonds Be Halal?
At first glance, it's easy to see how a revenue bond could be compared to Islamic investment certificates, or sukuk: both include an identifiable revenue source and are structured to pass income through to investors. For this reason, some have asked whether revenue bonds can be considered halal. While both security types generate investment returns from a specific project's profits or revenue stream, revenue bonds fail to meet several additional standards set by Islamic principles.
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For an investment certificate to be considered halal, it must meet several “CORE” criteria: Compliance with Islamic principles, Ownership of the security’s underlying assets, Risk-sharing among contractual parties, and Exposure to losses if the assets lose value. Municipal bonds – and any other type of traditional bonds that pay interest – fail to meet these requirements.
SURFACE SIMILARITIES BETWEEN SUKUK AND REVENUE BONDS:
✓ Both have a stated maturity and scheduled income distributions.
The CORE Criteria of Halal Investment Certificates
Compliance with Islamic Principles
One critical distinction between revenue bonds and Islamic investment certificates is the halal certification process. In order to be considered halal, an investment certificate must undergo and pass a religious review by a board of Islamic scholars prior to issuance. The board then issues a fatwa certifying compliance with Islamic investing standards.1 The examination includes the security’s structure and purpose as well as the business operations of the underlying assets. Not only must the security be structured to avoid paying interest, the assets financed must avoid involvement in businesses such as alcohol, tobacco, pork processing, and other activities prohibited by the Islamic faith.
FATWA “FAHT-wah”: A LEGAL OPINION OR DECREE HANDED DOWN BY AN ISLAMIC RELIGIOUS LEADER 2
Guidelines issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based Islamic financial standards organization, state that securities given a fatwa must also be subject to ongoing monitoring by an Islamic board. AAOIFI specifies that each security’s prospectus “must explicitly mention the obligation to abide by the [Islamic] rules and principles” and that an Islamic board must approve the issuance and monitor its implementation throughout its duration.3
While AAOIFI establishes rules and guidelines for market participants, it does not ascertain or opine as to whether any particular issuer’s security meets or exceeds them. Other Islamic financial standard-setting organizations, such as the Islamic Financial Services Board (IFSB) and the Islamic Fiqh Academy, aim to establish best practices. Despite their differences in approach, standard-setting organizations collectively agree on what constitutes an Islamic-compliant security. Conventional revenue bonds do not conform to these established parameters. The process of obtaining a fatwa is an important, distinguishing characteristic of what makes sukuk compliant with Islamic principles.
Ownership of Assets
Halal investing principles require that investment certificates, such as sukuk, be structured to ensure sharing of profits and when appropriate, losses. To accommodate the need for shared risk, halal non-equity income investment certificates must represent ownership or beneficial ownership interests (usufruct) in assets or a commercial enterprise. In the case of an asset-backed sukuk, for example, this requires a legal transfer of the assets from the originator to the investors.4
PAYMENTS TO THE CERTIFICATE HOLDERS ARE BASED ON THE NET PROFITS GENERATED BY THE UNDERLYING ASSETS
Payments to the certificate holders are based on the net profits generated by the underlying assets, and holders accept a share of any losses incurred. The issuer cannot guarantee the security’s investment return or establish a predetermined price (principal repayment) at the end of investment certificate’s tenure; hence establishing a true risk and profit-sharing relationship that results from ownership. Because revenue bonds are structured as debt repayment contracts, they do not fulfill the ownership component required of halal investment certificates.
Islamic economic thought prefers profit-sharing modes of financing in which the financier assumes some business risk. As a result, both the investor and the issuer of the investment certificate must share in the enterprise’s risks and returns. This is, in part, a primary reason why halal investing prohibits instruments that derive returns from interest payments on loans or debt – they fail to satisfy an important risk-sharing tenet of Islamic principles.
The distinction between interest and profit arises from the fact that they are earned in different ways. Profit is earned through business operations or assets subject to risk, while interest is obtained in a risk-reduced manner because the interest payments received have no direct relationship to the performance of the underlying assets. In effect, an interest-based loan is the sale of a given amount of money for more money. Islamic principles consider money to be an intermediary between goods, therefore charging interest on loans is considered unjust. The unbalanced risk allocation between revenue bond issuers and investors disqualifies revenue bonds as halal investments.
Exposure to Enterprise Risk
Conventional bondholders receive cash flows that are independent of profit or loss earned from the funds raised through issuing bonds. Unlike shareholders, bondholders receive rewards that have been determined and agreed upon in advance through a contractual agreement and covenants that obligate financial performance of the issuer regardless of how the underlying assets perform.
As a result, creditors are not exposed to the uncertainties, or risks, of the underlying assets or business enterprise but rather the creditworthiness of the issuer itself. In other words, creditors do not share the risks faced by the enterprise they finance. It is for this reason that interest-based bonds are risk-transferring rather than risk-sharing contracts. The ownership and risk-sharing structure of halal investment certificates exposes them to a risk of loss if the underlying assets lose value or the enterprise fails to produce a profit. Because revenue bond investors do not assume the risk of the underlying enterprise they finance, revenue bonds are not considered halal
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The best way to think about whether any security may be labeled halal is to determine whether the investment spreads risk and affords beneficial ownership to the parties involved. Does it include a risk-sharing component ensuring that investors' and issuers' interests are aligned? Does the investor have an ownership or beneficial ownership interest in assets or a commercial enterprise? Is the investment contract free of obligations or guarantees of investment results? Has the security undergone an Islamic review and obtained a fatwa ascertaining whether the security and issuer meet Islamic standards? The answer to these questions with regard to revenue bonds is a resounding "no." At their core, revenue bonds are not halal.
1 Rahail, A., Hogan, L. Sukuk and Islamic Capital Markets: A Practical Guide, Globe Law and Business, 2011.
2 Fatwa. Merriam-Webster.com. September 19, 2016 http://www.merriam-webster.com/dictionary/fatwa
3 Shari’a Standards for Islamic Financial Institutions, 1432 H, 2010. Accounting and Auditing Organisation for Islamic Financial Institutions, Standard 17, Investment Sukuk, p. 313. http://www.iefpedia.com/english/wp-content/uploads/2012/11/utoew.pdf
4 Hegazy, H. A Legal and Geopolitical Perspective on Sukuk in the GCC, Middle East Insights, Islamic Finance Special, Middle East Institute, National University of Singapore, August 4, 2016. https://mei.nus.edu.sg/themes/site_themes/agile_records/images/uploads/Download_Insight_IFS_6_Hegazy.pdf
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Investing involves risk, including possible loss of principal. Generally, an investment that offers a higher potential return will have a higher risk of loss. Stock prices fluctuate, sometimes quickly and significantly, for a broad range of reasons that may affect individual companies, industries, or sectors. When interest rates rise, bond prices fall. When interest rates fall, bond prices go up. A bond fund’s price will typically follow the same pattern. Investments in high-yield securities can be speculative in nature. High-yield bonds may have low or no ratings, and may be considered “junk bonds.” Investing in foreign securities involves risks not typically associated directly with investing in US securities. These risks include currency and market fluctuations, and political or social instability. The risks of foreign investing are generally magnified in the smaller and more volatile securities markets of the developing world.
In addition to the fixed-income market risks above, the Amana Participation Fund entails risks specific to investing in sukuk. Sukuk structures may be significantly more complicated than conventional bonds and often include a series of entities created specifically to support the sukuk structure. In addition, sukuk are largely created in or otherwise subject to the risks of developing economies, many of which have weak or inconsistent accounting, legal, and financial infrastructure. The structural complexity of sukuk, along with the weak infrastructure of the sukuk market, increases risks of investing in sukuk, including operational, legal, and investment risks.
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About the Author
Patrick Drum MBA, CFA®, CFP®
Portfolio Manager, Amana Participation Fund